Australia Central Bank Opens Door to Rate Cut

Australia's central bank on Tuesday opened the door to the first cut in interest rates for seven years, saying slowing demand and tight financial conditions were set to bring inflation down over time.

The Australian dollar slid half a U.S. cent and bonds rallied as investors priced in the first cut by September, perhaps even by half a percentage point.

While the Reserve Bank of Australia (RBA) left key rates steady at a 12-year peak of 7.25 percent at its August policy meeting, its statement clearly signalled a bias toward easing.

"With demand slowing, the Board's view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing," RBAGovernor Glenn Stevens said in a brief statement announcing the decision.

Given the global credit squeeze, rising fuel costs and falling asset values it was looking more likely that demand would remain subdued and economic growth would slow, said Stevens.

Inflation would remain high in the short term, having hit a 17-year peak of 4.4 percent last quarter. But the central bank was now more confident that inflation would slow to within its 2 to 3 percent target band by 2010.

"A rate cut in September is now almost certain," declared Rory Robertson, interest rate strategist at Macquarie.

Investors seemed to agree, with interest rate swaps showing a probability of around 92 percent for a 25 basis-point cut next month.

That marked a major turnaround from just a couple of months ago when markets were betting on a hike to 7.5 percent, following rate rises in February and March.

Retail sales suffered their biggest monthly fall in June for six years as consumer sentiment hit depths not seen since the recession of the early 1990s.

Crucially, borrowing by households and business has slumped as banks jacked up their lending rates while rationing credit. This extra market-driven tightening of financial conditions may have gone beyond what the RBA wanted.

"Financial conditions have tightened by more than the RBA planned or anticipated and the economic data is weak enough that the RBA will be worried about the risk of recession," argued Robertson at Macquarie.

A survey out early Tuesday illustrated how tough things had become in the services sector, which accounts for around two thirds of the economy.

The Australian Industry Group-Commonwealth Bank Performance of Services Index (PSI) fell 2.6 points in July to 42.8, well below the 50 level that separates contraction from expansion.

Perhaps most worrying was a sharp 6 point drop in the employment index to 42.2, a record low for the survey.

The labour market has been one of the most resilient parts of the economy and weakness here would greatly add to the case for early cuts in interest rates.

Official figures on employment for July are due on Thursday and analysts were already looking for only a marginal rise of 1,250 net new jobs in the month.

"If the unemployment rate starts to tick up, then we can expect the RBA to move sooner rather than later," said Su-Lin Ong, a senior economist at RBC Capital Markets.

"We are looking for a rate cut in early 2009, but there is clearly a risk it will happen in the last quarter of 2008."

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